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Bonus Deduction Timing: Finding the Correct Tax Year

It is common practice for an
employer to maintain an annual bonus plan to
attract, retain, and provide incentives to employees
who are key to the business’s growth. Employers
often spend a great deal of time designing a bonus
plan to meet these goals. But employers should not
stop there. They should also consider how the bonus
arrangements affect their income tax obligations at
the end of the year.

In most circumstances,
the optimal outcome is for the employer to deduct
the bonus in the year it is earned, rather than the
year it is paid. Many businesses believe that
as long as they pay the bonuses within 2½ months
after the end of the tax year in which the bonus
is earned, the bonus is deductible in the year it
is earned, rather than the year paid.
Unfortunately, this is not always true. Many
factors determine when the bonus is deductible.

This item focuses on an employer’s
ability to deduct bonuses in the tax year they are
earned rather than the tax year in which they are
paid to the employee. This includes a discussion of
a recently released IRS field attorney memorandum
(Field Attorney Advice (FAA) 20134301F). This item
refers to ABC Co., a
hypothetical employer that uses the accrual method
of accounting, and its employee, Tom, to illustrate
the deduction timing rules. ABC is a
calendar-year taxpayer that pays the bonus to Tom
within 2½ months after the end of ABC’s tax year in
which Tom earns the bonus (i.e., by March 15), which
avoids the deduction timing rules under Sec. 404
that apply to deferred compensation and that may
result in deferring the deduction until the year it
is paid.

Assuming ABC pays Tom his bonus within 2½ months after the
end of the tax year in which Tom earns the bonus,
Sec. 461 governs the timing of ABC’s tax deduction. If ABC were a cash-basis taxpayer, the timing of the
deduction would be simple. Regs. Sec.
1.461-1(a)(1) allows the deduction in the year the
bonus is paid. If ABC were a cash-basis taxpayer and paid Tom his
2013 bonus in February 2014, ABC would deduct the bonus in 2014.

The Sec. 461 rules are much more complex when
considering an accrual-method taxpayer. Regs. Sec.
1.461-1(a)(2) provides that under an accrual
method of accounting, a liability (e.g., an
accrued bonus) is incurred, and generally
deductible, in the tax year in which (1) all
events have occurred to establish the fact of the
liability, (2) the amount of the liability can be
determined with reasonable accuracy, and (3)
economic performance has occurred for the
liability. The first two prongs are referred to as
the all-events test. This test has received
increased attention over the past few years in the
form of official and unofficial IRS guidance.
These two prongs are the subject of this item. The
third prong, economic performance, is satisfied
when the employee performs the services related to
a bonus. This prong has not received increased
attention.

All-EventsTest

As discussed above, the all-events test is met in
the tax year in which (1) all events have occurred
to establish the fact of the liability, and (2) the
amount of the liability can be determined with
reasonable accuracy. When is the fact of a liability
established? In Rev. Rul. 79-410, the IRS addressed
how the all-events test applies to a noncompensation
accrued liability. In this ruling, the IRS stated
that “all events have occurred that determine the
fact of the liability when (1) the event fixing the
liability, whether that be the required performance
or other event, occurs, or (2) payment therefore is
due, whichever happens earliest.”

First, it is important to consider how this
would apply if a separate bonus plan is in place
for each employee, including Tom. Suppose Tom is
required to be employed only on the last day of
the tax year to receive the bonus payment, rather
than the bonus payment date. The amount of Tom’s
bonus is determined based on an objective formula
established before the end of the tax year that
takes into account ABC’s financial data as of the end of the year.
Generally, the fact of the liability is
established on Dec. 31, 2013, and the amount of
the liability is determinable at that time.
However, as discussed later, other provisions of
the bonus plan may cause the fact of the liability
not to be established until 2014, when the bonus
is paid.

Alternatively, suppose the facts are the same
as above, but Tom is required to be employed on
the bonus payment date to receive the bonus. If he
leaves before the bonus payment date, ABC retains the bonus. In this instance, the
event fixing the liability for the bonus is the
payment date because Tom is required to be
employed on that date. If Tom leaves before that
date, ABC is not required to pay the bonus to Tom or
any other employee. Thus, all events occur to
establish the fact of the liability on the bonus
payment date in 2014, resulting in a deduction for
the bonus in 2014.

Other factors
may cause the fact of the liability to be
established, and the amount of the liability to be
reasonably determinable, in 2013, even if the
employee is required to be employed on the bonus
payment date to receive the bonus. This typically
occurs in situations where the accrued bonus is
related to a group of employees instead of a single
employee.

For example, an employer may use a “bonus
pool” strategy, in which a bonus pool is allocated
to employees. The amount in the pool is determined
either (1) through a formula that is fixed before
the end of the tax year, taking into account
financial data reflecting results as of the end of
the tax year, or (2) through some other binding
corporate action that specifies the pool amount,
such as a board resolution made before the end of
the tax year.

Under ABC’s bonus pool,
Tom and the other employees are allocated a portion
of the bonus pool, but to receive the bonus payment,
the employees must be employed on the bonus payment
date. If Tom forfeits the bonus because he is no
longer employed on the bonus payment date, his bonus
is reallocated to the other employees who remain
with the company on that date. Thus, ABC will pay the
entire amount of the bonus accrual to employees. In
this situation, ABC’s bonus
liability is fixed at the end of the tax year
because it will pay the aggregate amount of the
bonuses. Also, the amount of the bonus liability is
reasonably determinable on Dec. 31, 2013, because
the amount is established through a formula or board
resolution in place on that date.

The company
may also employ a “minimum bonus” strategy, which
uses the bonus pool concept but allows the employer
to retain a specified amount of forfeited bonuses
rather than reallocating them to other employees.
Similar to the bonus pool concept, before year end,
ABC
establishes an aggregate amount of bonuses
that will be paid to the group of employees. It also
sets a minimum amount of the aggregate bonus pool
that ABC
will pay to employees and determines this
minimum amount by analyzing the trend of forfeited
bonuses in prior years.

For example, over the
past five years, on average, 6% of bonuses have been
forfeited by employees who left before the bonus
payment date. To be conservative, ABC estimates
that employees will forfeit no more than 10% of the
aggregate bonuses, and before the end of the tax
year, mandates that it will pay out at least 90% of
the aggregate bonus amount to employees. To the
extent that the bonuses actually paid to employees
are less than 90% of the aggregate bonus amount,
ABC pays
additional bonuses to reach the 90% threshold.

The IRS considered this minimum bonus strategy
in Rev. Rul. 2011-29 to determine whether the fact
of the bonus accrual liability is established at
year end. The IRS recognized that the employer is
obligated under the bonus plan to pay the group of
employees the minimum amount of the bonuses
determined by the end of the year. Applying this
to ABC’s bonus, the liability is established at the
end of the year for 90% of the aggregate bonus
pool. The fact of the liability for any bonuses
paid in excess of the 90% minimum amount is not
established until those bonuses are paid. The IRS
didn’t consider the second prong of the all-events
test—when is the amount of the liability
determinable with reasonable accuracy—in Rev. Rul.
2011-29, but it is clear that the amount was
determined on the last day of the tax year because
of the fixed formula or board resolution. Thus,
assuming economic performance occurred on Dec. 31,
2013, under Rev. Rul. 2011-29, ABC may deduct the 90% minimum bonus amount in
2013 and deduct any amount paid in excess of the
minimum amount in 2014.

Traps for the Unwary

In FAA
20134301F, the IRS analyzed when an employer could
take a tax deduction for bonuses paid to employees.
The employer in this memorandum sponsored multiple
bonus plans that paid cash awards to employees. The
employees had to be employed on the last day of the
tax year to receive the bonuses, but not on the
bonus payment date. The bonus was paid after the end
of the employer’s tax year, but within 2½ months
after the end of the tax year. The scenario
described above considered the situation where Tom
was required to be employed on the last day of the
tax year but not on the bonus payment date. Under
that scenario, the all-events test was met on the
last day of the tax year. In the field attorney
memorandum, however, the IRS pointed out factors
that could cause the bonus liability not to meet the
all-events test at the end of the tax year.

The plans in the memorandum provided that the
employer retains the unilateral right to modify or
eliminate the bonuses at any time before payment.
The IRS concluded that the bonus plans did not meet
the all-events test until the bonuses were paid to
the employees, because the fact and amount of the
liability were not established until that date.
Because the employer had the right to unilaterally
eliminate or reduce the bonuses at any time prior to
payment, the employer had no legal obligation to pay
the bonuses. As a result, according to the
memorandum, the all-events test was not met at the
end of the tax year.

The IRS considered a
number of nontax court cases in reaching this
conclusion. The cases focus on state law and an
employer’s legal obligation to pay compensation to
employees when the employer retains the unilateral
right not to pay the compensation. The IRS concluded
that this type of unilateral right did not create a
contract between the employer and employee. Even if
it did create a contract, there would be no breach
of contract for failure to pay the bonuses. As a
result, the bonus plan did not fix the employer’s
liability to pay the bonuses prior to payment of the
bonuses.

Some of the bonus plans addressed in
the memorandum compute the amount of the bonuses
using preestablished objective performance criteria.
The employer did not pay the bonuses to the
employees until after a committee of the employer’s
board of directors approved the bonus plan payment,
which did not occur until after the end of the tax
year. The committee had the ongoing right to adjust
the bonuses before they were paid. The IRS found
that the committee’s approval was more than a
ministerial act. Thus, according to the memorandum,
the all-events test was not met until the committee
approved the bonuses and their payment, because no
bonus was paid without the committee’s approval,
which was not automatic. Thus, the employer did not
meet the all-events test as of the end of the tax
year.

The formulas used to calculate the
employees’ bonuses discussed in the memorandum are
driven by one or more metrics, some of which are not
fixed at year end. In some instances, the formula
takes into account the employee’s individual
performance appraisals, which are not conducted
until after the end of the year, and therefore are
not fixed at year end. The IRS concluded that where
bonus amounts are dependent in whole or in part on
some subjective determination made after year end
(e.g., a performance appraisal), the all-events test
is not met at year end because the subjective
determination is one event that fixes the fact and
amount of the liability.

This field attorney
memorandum demonstrates the importance of paying
close attention to a bonus plan’s provisions. A plan
provision that gives the employer discretion to
adjust or eliminate the bonus amount after the end
of the tax year likely results in the all-events
test’s not being met at the end of the tax year.
Also, using a formula to determine the amount of the
bonus may be an optimal design strategy, but a
formula that looks at subjective factors after the
end of the tax year is a fatal flaw when attempting
to meet the all-events test on the last day of a tax
year.

Public Companies: Sec.
162(m)

Public corporations that attempt to avoid the
$1 million compensation deduction limitation in
Sec. 162(m) may find challenges when they also
attempt to deduct bonuses in the year bonuses are
earned rather than the year the bonuses are paid.
In general, Sec. 162(m) limits a public
corporation’s annual income tax deduction to $1
million for compensation paid to a covered
employee. A covered employee includes the
corporation’s principal executive officer and the
three highest-paid executives other than the
principal executive officer and principal
financial officer. Performance-based compensation
is not subject to the $1 million compensation
deduction limitation. Public company employers
often structure executive bonus plans to meet the
performance-based compensation requirements.

To qualify as performance-based
compensation, the corporation must establish the
compensation plan within 90 days of the beginning of
the performance period and must state, in terms of
an objective formula or standard, the method for
computing the amount of compensation payable to the
executive. The plan may not allow for discretion to
increase the amount payable, but it may provide for
discretion to reduce or eliminate the compensation
payable under the plan.

For example, ABC implements the bonus pool strategy for the
bonus plan in which the executives participate.
Under this strategy, if Tom leaves before his
bonus is paid, he forfeits the bonus, and ABC allocates it to the other executives. Thus, ABC has discretion to increase the bonuses
payable to the other executives, which violates
the performance-based compensation requirements if
the other executives are covered employees.

This same conclusion is reached if ABC implements the minimum bonus strategy, because
if the total amount of the bonuses paid to the
executives does not reach the minimum percentage, ABC must allocate additional bonuses to the other
executives who are covered employees. Thus, it may
not be practical for a public company to use one
of these strategies for its executive bonus plan.

This does not mean it is impossible for
a public company’s executive bonus accrual to meet
the all-events test in the performance year while
also qualifying as performance-based compensation.
The plan may provide that the executives are
required to provide services only until the last day
of the tax year. In that situation, the all-events
test generally is met on that date. Alternatively,
under the bonus pool strategy, the plan may provide
that any executive who is not employed on the bonus
payment date forfeits the bonus, but the forfeited
amount will not be reallocated to covered employees.
A corporation can apply the same approach to the
minimum bonus strategy.

Some public companies
have implemented what sometimes is referred to as a
“plan within a plan” for paying bonuses to covered
employees. The plan states that the company will pay
a very high bonus target amount to the covered
employee if the performance goals are met. The plan
then gives the compensation committee discretion to
reduce the bonus amount, often taking into account
subjective performance goals. This gives the
compensation committee discretion to pay the
executive what it deems appropriate, as long as the
high bonus target is not exceeded. Unfortunately,
this type of discretion results in the all-events
test’s not being met until the bonus is paid to the
employee. The fact of the liability is not
established on the last day of the tax year because
the compensation committee can reduce the bonus
amount after the end of the year.

Summary

Determining the deduction
timing of accrued bonuses is not as simple as it may
seem. Merely paying the bonus within 2½ months after
the end of the tax year will not always result in a
deduction in the bonus performance year rather than
the year the bonus is paid. Employers and tax return
preparers should pay close attention to the
provisions and operations of the bonus plan before
reaching a conclusion on the timing of the
deduction. All is not lost for employers that
require their employees to still be employed on the
bonus payment date to receive payment. Employers can
implement strategies so the all-events test is met
at the end of the tax year. However, traps for the
unwary can ruin good intent.

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